Economics For Managers Ch. 9 & 10 Technical And Application Questions

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Utilizing the attached PDF, answer the following questions that are included in the PDF:

  1. Work the following problems in Chapter 9: Application questions 3, 4, 5, and 6.
  1. Work the following problems in Chapter 10: Technical questions 1, 2, 3, 4, and 5.
  2. Work the following problems in Chapter 10: Application questions 2, 3, 4, 5 and 6.

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9 Market Structure: Oligopoly I n this chapter, we examine the fourth market model, oligopoly. This model is close to the monopoly model and at the other end of the market structure spectrum from the model of perfect competition. Oligopoly firms typically have market power derived from barriers to entry. However, the key characteristic of oligopoly is that there are a small number of firms competing with each other, so their behavior is mutually interdependent. This interdependence distinguishes oligopoly from all other market structures. In perfect competition and monopolistic competition, there are so many firms that each firm doesn’t have to consider the actions of other firms. If a monopolist truly is a single firm producing a product with no close substitutes, it can also form its own independent strategies. However, when 4, 6, or 10 major firms compete with each other, behavior is interdependent. The strategies and decisions by managers of one firm affect managers of other firms, whose subsequent decisions then affect the first firm. This chapter begins with the case of interdependent behavior in airline pricing. We’ll then examine additional cases of oligopoly behavior drawn from the news media. Next we’ll look at several models of oligopoly to see how economists have modeled both noncooperative and cooperative interdependent behavior. The goal is not to cover the huge number of oligopoly models that have been developed over the years, all of which attempt to illustrate different aspects of interdependent behavior. Instead, we’ll present the insights of a few models and then illustrate these principles with descriptions of real-world oligopolistic behavior. We’ll conclude by describing how government antitrust legislation and enforcement influence oligopoly behavior. 260 M09_FARN0095_03_GE_C09.INDD 260 13/08/14 1:33 PM Case for Analysis Oligopoly Behavior in the Airline Industry Oligopolistic airline pricing behavior has occurred for many years. There are a small number of players in the airline industry, so that price changes by one airline affect the demand for flights of its competitors. As discussed later in this chapter, overt price fixing is illegal in this country and even tacit collusion can be dangerous for firms in terms of antitrust enforcement. Thus, the airlines often try to coordinate their strategies with one company taking a leadership role and then watching for the reactions of its competitors. Price changes are usually implemented on Thursdays or Fridays, so that the lead airline can watch the reaction over the weekend and then make adjustments by Monday. These reactions typically vary by the size and market power of the airline and may differ by the route flown. These behaviors have often been characterized as an intricate chess game. In March 2002, American Airlines increased its three-day advanced purchase requirement on low-priced business tickets to seven days with the hope that competitors would follow this implicit price increase.1 When the competitors refused to do so, American retaliated by offering deep discounts on business fares in several of the competitors’ markets. In response, Northwest Airlines began offering $198 round-trip fares with connections on three-day advanced purchase tickets in 160 of American’s nonstop markets, where the average unrestricted business fare was $1,600. American then offered $99 one-way fares in 10 markets each flown by Northwest, United, Delta, and US Airways. Only Continental Airlines’ markets were excluded from these low fares, an outcome that probably resulted because Continental had matched American’s original change in all markets. In March 2004, Continental Airlines tried to raise its fares across the board to cover the rising cost of fuel. Low-cost rivals Southwest and JetBlue refused to follow because they had protected themselves against rising fuel costs with hedging agreements. Continental hedged fuel for 2003 but stopped 1 Scott McCartney, “Airfare Wars Show Why Deals Arrive and Depart,” Wall Street Journal, March 19, 2002. buying the contracts when they became more expensive due to the rising oil prices. For an entire month, one airline or another tried to impose network-wide fare increases but had to back off because all of their rivals would not follow the increases except on certain routes.2 By spring 2005, the airlines had some greater pricing power, having achieved seven fare increases in the first five months of the year. Demand for airline seats had been increasing, particularly with the approach of summer. In May 2005, the price increase was led by American Airlines and was imposed even in markets where it competed with Southwest. As of the Friday afternoon when it was announced, Delta, Continental, Northwest, United, and US Airways had all matched the increase in varying combinations.3 By 2011 and 2012, high fuel prices forced most airlines to attempt to raise fares.4 In February 2011, Delta led the increase and was quickly followed by American. However, given the impact of the slow recovery from the economic recession in 2008, both airlines backed off from the fare increases later in the week. These decisions were also influenced by the reaction of Southwest Airlines, the largest discount carrier in the United States, which did not raise prices. In early 2012, the airlines, which had quietly raised prices for the last half of 2011, continued to try to do so even before the summer 2012 travel season. It appeared that at this time even Southwest Airlines was more willing to accept the price increases than it had in the past. 2 Elizabeth Souder, “Continental Attempts Fare Hike, But Rivals Won’t Budge,” Wall Street Journal, March 26, 2004. 3 Melanie Trottman, “U.S. Airlines Attempt New Round of Fare Increases,” Wall Street Journal, May 16, 2005. 4 This discussion is based on Gulliver, “The Big Airlines Get Cold Feet,” The Economist (Online), February 20, 2011; and Kelly Yamanouchi, “Airlines Keep Adapting to High Fuel Costs,” Atlanta Journal Constitution (Online), March 4, 2012. 261 M09_FARN0095_03_GE_C09.INDD 261 13/08/14 1:33 PM 262 PART 1 Microeconomic Analysis Case Studies of Oligopoly Behavior Oligopoly A market structure characterized by competition among a small number of large firms that have market power, but that must take their rivals’ actions into account when developing their own competitive strategies. The behavior just described represents the interdependence of firms operating in an oligopoly market. This behavior has become more pervasive as oligopolies have come to dominate many industries in the United States, as shown in Table 9.1. We next discuss oligopoly behavior in several key industries. The Airline Industry In addition to the pricing strategies discussed in the opening case study, there are numerous other examples of oligopoly behavior in the airline industry. In the late 1990s, Frontier Airlines was the small upstart carrier trying to compete with United Airlines, particularly at the Denver airport. Frontier developed strategies to compete with its rival by “getting inside United’s corporate head, anticipating its moves and countermoves, and chipping away as much business as it can get away with.”5 Frontier officials developed aggressive strategies on pricing and flight scheduling, but restrained these strategies enough to avoid provoking a substantial competitive response from United, which would have had a detrimental impact on Frontier. Frontier learned from experience that United was likely to tolerate not more than two flights a day to one of its competitive cities and that timing Frontier’s flights outside United’s windows of connecting flights would make United unlikely to establish a new head-to-head competing flight. Frontier’s managers also waited to announce the company’s new flights from United’s hub at Denver International Airport to Portland, Oregon, until United had loaded its summer schedule into the computer system. This tactic made it difficult for United to rearrange its published schedule of flights to compete against Frontier. Frontier’s pricing strategy was to raise ticket prices enough to avoid a price-cutting response from United, but to keep prices low enough to appeal to customers and attract new business. Setting TABLE 9.1 Oligopolistic Industries in the United States INDUSTRY NUMBER OF FIRMS MARKET SHARE (PERCENT) Carbonated soft drinks 3 80 Beer 3 80 Cigarettes 3 80 Recorded music 4 80 Railroad operations 4 100 Movies 6 85 Razors and razor blades 3 95 Cookies and crackers 2 80 Carpets 2 75 Breakfast cereals 4 80 Light bulbs 2 85 Consumer batteries 3 90 Source: Stephen G. Hannaford, Market Domination! The Impact of Industry Consolidation on Competition, Innovation, and Consumer Choice (Westport, CT: Praeger, 2007), 5. Reprinted by permission. 5 Scott McCartney, “Upstart’s Tactics Allow It to Fly in Friendly Skies of a Big Rival,” Wall Street Journal, June 23, 1999. M09_FARN0095_03_GE_C09.INDD 262 13/08/14 1:33 PM CHAPTER 9 Market Structure: Oligopoly 263 prices far below those of United would have resulted in United not only lowering prices, but also scheduling many more flights to compete with Frontier. However, United’s managers needed to make certain that their competitive strategies did not violate U.S. antitrust laws. The U.S. Justice Department had previously accused American Airlines of cutting prices and increasing capacity to stifle new competition in its Dallas–Fort Worth hub airport. By the summer of 2003, there was a three-way struggle among United, which was now reorganizing its business in bankruptcy court; Frontier, the growing low-cost airline; and the city of Denver, which operated the city’s airport, the hub for this competition.6 Frontier claimed that while United’s market share at the Denver airport had declined from 74 to 64 percent, the airport had increased the number of United’s gates from 43 to 51. Frontier’s market share had more than doubled, increasing from 5.6 to 13.3 percent, while the number of its gates increased from only 6 to 10. United also demanded that the city build a new $65 million regional jet terminal with an additional 38 gates. United wanted to hold its existing gates for future expansion, while Frontier argued that it could put many of those gates to more productive use. The city was caught between the demands of its dominant airline, which had less market power than before 1999, and those of the aggressive low-cost competitor. Competition for amenities has been another aspect of oligopolistic strategies, particularly among international airlines. Lufthansa Airlines opened a first-class terminal in Frankfurt in 2005 where passengers could have a bubble bath, rest in a cigar room, and be driven to the plane in a Mercedes or Porsche. Middle Eastern carriers have installed lavish closed-door suites in the front of planes, while Virgin Atlantic opened a Clubhouse at London’s Heathrow Airport with a beauty salon, cinema, and Jacuzzi.7 In the fall of 2007, Singapore Airlines began the first commercial flight of the Airbus A380, the biggest passenger jet ever built, with 12 firstclass passengers housed in fully enclosed cabins with expandable beds, while 60 seats in business class were 34 inches wide—twice the width of a typical economy seat.8 Competition on lie-flat seating began in 1999 when Virgin Atlantic Airways introduced a flying bed for its Upper Class cabin that was slightly less than horizontal. British Airways responded by unveiling a fully horizontal business-class lie-flat seat in 2000. Virgin countered in 2003 with a bigger lie-flat seat angled to the aisle, herringbone style with seats arranged head to toe. Delta adopted the herringbone style, while Deutsche Lufthansa announced a Flying V style pattern in 2012 that paired seats with feet closer together than heads.9 By the spring of 2008, with the slow economy and oil prices exceeding $130 per barrel, all of the major U.S. airlines were adopting similar strategies to cut costs and raise prices. In June 2008, United Airlines followed the lead of American Airlines in charging passengers for the first checked bag. United had been the first airline to charge for the second checked bag in February 2008, and rivals soon followed. The airlines grounded planes and removed flights from schedules to limit the supply of seats and raise prices. They also searched for new ways to reduce costs, including installing winglets on jets to improve performance, eliminating magazines in cabins to reduce weight, carrying less fuel above required reserve levels, and washing jet engines with new machines that could deep clean while collecting and purifying the runoff.10 6 Edward Wong, “Denver’s Idle Gates Draw Covetous Eyes,” New York Times, August 5, 2003. Scott McCartney, “A Bubble Bath and a Glass of Bubbly—at the Airport,” Wall Street Journal, July 10, 2007. 8 Bruce Stanley and Daniel Michaels, “Taking a Flier on Bedroom Suites,” Wall Street Journal, October 24, 2007. 9 Daniel Michaels, “Airlines Escalate Race in Lie-Flat Seating,” Wall Street Journal (Online), March 8, 2012. 10 Scott McCartney, “As Airlines Cut Back, Who Gets Grounded?” Wall Street Journal, June 6, 2008; Scott McCartney, “Flying Stinks—Especially for the Airlines,” Wall Street Journal, June 10, 2008; Jessica Lynn Lunsford, “Airlines Dip into Hot Water to Save Fuel,” Wall Street Journal, June 11, 2008; Mike Barris, “United Matches American Airlines in Charging for First Checked Bag,” Wall Street Journal, June 13, 2008. 7 M09_FARN0095_03_GE_C09.INDD 263 13/08/14 1:33 PM 264 PART 1 Microeconomic Analysis The Soft Drink Industry Although Coca-Cola Company and PepsiCo Inc. have long battled each other in the cola wars, their interdependent behavior has moved into the bottled water market with Coke’s Dasani and Pepsi’s Aquafina brands.11 Although bottled water comprised less than 10 percent of each company’s beverage sales in 2002, bottled water sales in the United States grew 30 percent in 2001 compared with 0.6 percent growth for soft drinks. The bottled water market in 2001 was dominated by a few large firms: Nestle’s Perrier Group (37.4 percent market share), Pepsi (13.8 percent), Coca-Cola (12.0 percent), and Danone (11.8 percent). Coke and Pepsi tried to avoid the pricing wars in grocery stores that occurred with the colas, so they concentrated on selling single, cold bottles in convenience stores or vending machines. However, price discounting was already occurring in some grocery stores as more consumers bought water to take home. The rivals also focused on making the product readily available and packaging the water in convenient and attractive bottles. Pepsi launched its Aquafina in a new bottle with a transparent label, while Coke developed a Dasani bottle with a thin, easy-to-grip cap for sports enthusiasts. The rivals have used different strategies to market goods that are virtually identical. Coke developed a combination of minerals to give Dasani a clean, fresh taste. The formula for this mix is kept as secret as the original Coke formula. Managers also paid much attention to developing the Dasani name, which was intended to convey crispness and freshness with a foreign ring. Pepsi claimed that Aquafina was purer because nothing was added to its exhaustively filtered water and focused its marketing activities around customers “wanting nothing.” Both companies developed enhanced versions of their waters. Coke launched Dasani Nutriwater, with added nutrients and essences of pear and cucumber, in late 2002, while Pepsi introduced Aquafina Essentials, with vitamins, minerals, and fruit flavors, in the summer of 2002. In a joint venture with Group Danone, Coke also took over distribution of Dannon bottled water, which gave the company a low-priced brand that would complement the mid-priced Dasani. By 2008 the two rivals were both managing a complex portfolio of drinks, given that U.S. consumers were buying fewer soft drinks and more beverages such as teas, waters, and energy drinks. From 2003 to 2008 noncarbonated beverages grew from one-quarter to one-third of the nonalcoholic beverage market. Pepsi diversified first by signing joint ventures with Lipton in 1991 and Starbucks in 1994 and acquiring SoBe in 2000 and Gatorade in 2001. These moves gave it the lead in teas, ready-to-drink coffees, and sports drinks. Coca-Cola countered by buying Glaceau enhanced waters and Fuze juice drinks and reaching agreements for Campbell’s juice drinks and Caribou and Godiva bottled coffees. Coke and Pepsi continue to try to gain an advantage even in small markets by searching for nuances or trends to determine the best product mix.12 The cola wars heated up again in 2011 and 2012 when in March 2011 it was announced that Pepsi had fallen to No. 3 in U.S. soda sales, trailing both Coke and Diet Coke.13 Coke had battled Pepsi ever since Coke’s founding in 1886 and Pepsi’s 11 Betsy McKay, “Pepsi, Coke Take Opposite Tacks in Bottled Water Marketing Battle,” Wall Street Journal, April 18, 2002; Scott Leith, “Beverage Titans Battle to Grow Water Business,” Atlanta Journal-Constitution, October 31, 2002. 12 Joe Guy Collier, “Cola Wars Aren’t Just About Cola Any More,” Atlanta Journal-Constitution, March 28, 2008. 13 This discussion is based on Natalie Zmuda, “How Pepsi Blinked, Fell Behind Diet Coke: Rough Patches, Risky Moves Cost It Share: Will Return to Basics Be Enough to Get It Back in the Game?” and “Coke Vs. Pepsi: A Timeline,” Advertising Age (Online), 82 (March 21, 2011), 1; Mike Esterl and Valerie Bauerlein, “PepsiCo Wakes Up and Smells the Cola,” Wall Street Journal (Online), June 28, 2011; and Mike Esterl and Paul Ziobro, “PepsiCo Overhauls Strategy,” Wall Street Journal (Online), February 10, 2012. M09_FARN0095_03_GE_C09.INDD 264 13/08/14 1:33 PM CHAPTER 9 Market Structure: Oligopoly 265 founding in 1898. Pepsi was accused of changing its focus from cola to products that are “better for you” and engaging in activities such as the Refresh Project, which gave grants to consumers with “refreshing ideas that change the world,” but may not have helped the company’s profits. In 2010 and early 2011, the company set a goal of more than doubling revenue from its nutritious products by 2020 while developing a corporate image focusing on health and global responsibility. In response to the loss of market share, Pepsi announced in 2012 that it was cutting 8,700 jobs and increasing its marketing budget by $600 billion that year with most of this budget directed to five key brands: Pepsi, Mountain Dew, Gatorade, Tropicana, and Lipton. In February 2012, the company ran its first Super Bowl TV ad for Pepsi in three years. The Doughnut Industry In the summer of 2001, Krispy Kreme Doughnuts of Winston-Salem, North Carolina, announced its plans to open 39 outlets in Canada over the following six years to compete directly with Tim Hortons—an American-owned, but Canadian-operated chain that is considered to be somewhat of a national institution in Canada.14 Canada is a profitable market because the country has more doughnut shops per capita than any other country. Tim Hortons was already the second-largest food service company in Canada, with 17 percent of quick-service restaurant sales. It drove out much of the competition through efficient service and aggressive tactics, such as opening identical drive-through outlets on opposite sides of the same street to attract customers traveling in either direction. Krispy Kreme is another large company, with $448.1 million in sales in 2001 and 192 stores across 32 states. As Krispy Kreme managers made the decision to move north to Canada, Tim Hortons’ managers were expanding south, focusing on U.S. border cities such as Detroit and Buffalo. The company had also invaded Krispy Kreme’s territory by opening two stores in West Virginia and one in Kentucky. Both companies engaged in product differentiation, with Tim Hortons emphasizing its product diversity— soups and sandwiches as well as doughnuts—while Krispy Kreme focused on its signature product—hot doughnuts. Tim Hortons also relied on its Canadian roots to ward off the competition from its U.S. competitor by using “We never forget where we came from” as its advertising theme in Canada. The doughnut battle in Canada appears to be between these two oligopolistic competitors, who are directly countering each other’s strategies. Dunkin’ Donuts Inc., the world’s largest doughnut chain, with 5,146 stores in 39 countries, has been in Canada since 1961, but owns only 6 percent of the Canadian doughnut/coffee shops. Tim Hortons has continued its expansion in the United States, confronting both Krispy Kreme and Dunkin’ Donuts. In 2007 most of its 340 stores in the United States were near the Canadian border in Michigan, Ohio, and upstate New York. By the end of 2008, the company had a goal of 500 U.S. stores, assuming it could establish a presence in New England, the home of Dunkin’ Donuts. Although Hortons’ style was more similar to Dunkin’ than Starbucks, the company tried to differentiate itself from Dunkin’ by offering more comfortable seats, china mugs, and cheaper coffee. Hortons has a strong association with coffee, although little name recognition in the United States. The company has encouraged its franchisees to get involved with local communities by sponsoring sports teams and summer camps.15 14 Joel Baglole, “Krispy Kreme, Tim Hortons of Canada Square Off in Each Other’s Territory,” Wall Street Journal, August 23, 2001. 15 Douglas Belkin, “A Canadian Icon Turns Its Glaze Southward,” Wall Street Journal, May 15, 2007. M09_FARN0095_03_GE_C09.INDD 265 13/08/14 1:33 PM 266 PART 1 Microeconomic Analysis Dunkin’ Donuts also tried to expand in the South, the West, and overseas by designing stores similar to coffeehouses and adding more sandwiches. This change in strategy came at a time when McDonald’s had moved toward selling lattes and cappuccinos to the same type of customer. The challenge for Dunkin’ was to decide how much style to add to its brand. Some of the new stores were painted in coffee-colored hues until long-time customers indicated they wanted more of the old bright pink and orange. A new hot sandwich was renamed a “stuffed melt” after customers complained that calling it a “panini” was too fancy. Research showed that Dunkin’s customers were unpretentious and disliked the more stylized chains such as Starbucks. This research concluded that the Dunkin “tribe” members wanted to be part of the crowd, while members of the Starbucks tribe had a desire to stand out as individuals. Dunkin managers also decided to keep the goal of moving its customers through the cash register line in two minutes compared with Starbuck’s goal of three minutes.16 When Dunkin’ went public in 2011, it announced that it had experienced 45 consecutive quarters of positive comparable store-sales growth until the recession in 2008 and 2009.17 The company had 206 net new store openings in 2010, planned to develop existing markets east of the Mississippi River, and also had international expansion plans, particularly in South Korea and the Middle East. Tim Horton’s was still primarily focused in Ontario, Canada and had achieved only limited profitability with the stores it had opened in the northern U.S. The Parcel and Express Delivery Industry United Parcel Service (UPS) and Federal Express (FedEx) control approximately 80 percent of the U.S. parcel and express delivery services, with UPS having a 53 percent market share and FedEx a 27 percent share. Although these two firms are normally intense rivals, in early 2001 they formed an alliance to keep a third competitor, the German firm Deutsche Post AG, out of the U.S. market.18 Both companies filed protests with the U.S. Department of Transportation, alleging that the German company was trying to get around U.S. laws to subsidize an expansion in the United States with profits from its mail monopoly in Germany. The U.S. companies contended that it was unfair for the German firm, which was partially owned by the German government, to compete in the United States because the U.S. Postal Service was not allowed to deliver packages in other countries. Deutsche Post AG owned a majority stake in Brussels-based DHL International Ltd., which had a stake in its U.S. affiliate, DHL Airways of Redwood City, California. UPS and FedEx contended that DHL International and Deutsche Post AG had essentially taken control of DHL Airways, placing that company in violation of federal laws prohibiting foreign ownership of more than 25 percent of a U.S. air carrier. UPS and FedEx tried to block expansion of the German firm in the United States at the same time the U.S. companies tried to expand in Europe. That expansion was countered by Deutsche Post AG, as the German firm lowered its parcel-delivery prices in light of increased U.S. competition. UPS and FedEx 16 Janet Adamy, “Dunkin’ Donuts Tries to Go Upscale, But Not Too Far,” Wall Street Journal, April 8, 2006; Janet Adamy, “Dunkin Donuts Whips Up a Recipe for Expansion,” Wall Street Journal, May 3, 2007. 17 This discussion is based on Lynn Cowan, “As Dunkin’ Donuts Goes Public, It’s Time to Question the Valuation,” Wall Street Journal (Online), July 26, 2011; John Jannarone, “Doughnut IPO a Slam-Dunk with Investors,” Wall Street Journal (Online), July 28, 2011; and Andrew Bary, “Dunkin’ Brands Shares Look Too Pricey to Sample,” Wall Street Journal (Online), September 4, 2011. 18 Rick Brooks, “FedEx, UPS Ask U.S. to Suspend DHL Flights, Freight Forwarding,” Wall Street Journal, January 24, 2001; Rick Brooks, “FedEx, UPS Join Forces to Stave Off Foreign Push into U.S. Delivery Market,” Wall Street Journal, February 1, 2001. M09_FARN0095_03_GE_C09.INDD 266 13/08/14 1:33 PM CHAPTER 9 Market Structure: Oligopoly 267 faced relatively weak competition in the U.S. delivery market and attempted through coordinated behavior to block entry by the German competitor. DHL did enter the U.S. package delivery industry in 2003, although the company was still unprofitable in 2007. DHL captured 7 percent of the U.S. market by 2005 when it announced that it was “not setting out to create another UPS or FedEx.” The company’s reputation suffered from a difficult hub consolidation in 2005 that cost it customers and revenue. In the spring of 2008, DHL announced that it was planning to transfer its North American air-parcel deliveries to UPS and cut its U.S. network capacity on the ground by one-third. In November 2008, the company announced that it was ending its domestic U.S. deliveries by January 2009, while continuing delivery and pickup of international shipments. Blaming its cutbacks on both competition from UPS and FedEx and the declining economy, DHL planned to shut its 18 U.S. ground hubs, reduce the number of delivery stations from 412 to 103, and eliminate 9,500 jobs.19 By 2011, DHL rebuilt its U.S. operations around international shipments with sales of approximately $1 billion per year. The company had a daily volume of 115,000 international packages compared with a daily load of 1.2 million parcels before the 2008 pullback. The attempt to compete with UPS and FedEx cost DHL $9.6 billion in 2008 and was called a “disaster” by DHL managers. Analysts have stated that UPS and FedEx were “tickled pink” not to have DHL as a domestic rival because DHL had entered the United States with lower rates than the other two companies. UPS earned an average revenue per domestic package of $8.20 in 2004, which increased to $8.85 in 2010.20 Oligopoly Models Economists have developed a variety of models to capture different aspects of the interdependent behavior inherent in oligopoly, although none of the models incorporates all elements of oligopolistic behavior.21 The many models can be divided into two basic groups: noncooperative and cooperative models. In noncooperative oligopoly models, managers make business decisions based on the strategy they think their rivals will pursue. In many cases, managers assume that their rivals will pursue strategies that inflict maximum damage on competing firms. Managers must then develop strategies of their own that best respond to their competitors’ strategies. The implication of many noncooperative models is that firms would be better off if they could cooperate or coordinate their actions with other firms. This outcome leads to cooperative oligopoly models—models of interdependent oligopoly behavior that assume that firms explicitly or implicitly cooperate with each other to achieve outcomes that benefit all the firms. Although cooperation may benefit the firms involved, it can also set up incentives for cheating on the cooperative behavior, and it may be illegal. The above discussion of UPS and FedEx shows that oligopolists may engage in noncooperative behavior with each other and cooperative behavior to keep out further competition. Noncooperative oligopoly models Models of interdependent oligopoly behavior that assume that firms pursue profit-maximizing strategies based on assumptions about rivals’ behavior and the impact of this behavior on the given firm’s strategies. Cooperative oligopoly models Models of interdependent oligopoly behavior that assume that firms explicitly or implicitly cooperate with each other to achieve outcomes that benefit all the firms. 19 Andrew Ward, “DHL Reins in Its Ambitions in U.S. Market,” Financial Times, May 18, 2005; William Hoffman, “Debating DHL’s Gains,” Traffic World, May 21, 2007; Corey Dade, “FedEx Cuts Outlook as Conditions Worsen,” Wall Street Journal, March 21, 2008; Mike Esterl and Corey Dade, “DHL Sends an SOS to UPS in $1 Billion Parcel Deal,” Wall Street Journal, May 29, 2008; Corey Dade, Alex Roth, and Mike Esterl, “DHL Beats a Retreat from the U.S.,” Wall Street Journal, November 8, 2008. 20 Natalie Doss and Mary Jane Credeur, “With Overseas Delivery, DHL Rebuilds,” Transport Topics (Online), April 25, 2011. 21 Many of these economic models are extremely mathematical. For a summary discussion, see Tonu Puu, Oligopoly: Old Ends—New Means (Berlin: Springer-Verlag, 2011). M09_FARN0095_03_GE_C09.INDD 267 13/08/14 1:33 PM 268 PART 1 Microeconomic Analysis Noncooperative Oligopoly Models Let’s now look at several models of noncooperative oligopoly behavior in which managers of competing firms make judgments and assumptions about the strategies that will be adopted by their rivals. The Kinked Demand Curve Model Kinked demand curve model An oligopoly model based on two demand curves that assumes that other firms will not match a firm’s price increases, but will match its price decreases. FIGURE 9.1 Kinked Demand Curve Model of Oligopoly The kinked demand curve model of oligopoly incorporates assumptions about interdependent behavior and illustrates why oligopoly prices may not change in reaction to either demand or cost changes. One of the simplest models of oligopoly behavior that incorporates assumptions about the behavior of rival firms is the kinked demand curve model, shown in Figure 9.1. The kinked demand curve model assumes that a firm is faced with two demand curves: one that reflects demand for its product if all rival firms follow the given firm’s price changes (D1) and one that reflects demand if all other firms do not follow the given firm’s price changes (D2). Demand curve D1 is relatively more inelastic than demand curve D2 because D1 shows the effect on the firm’s quantity demanded if all firms follow its price change. For example, if the firm considers raising the price above P1, its quantity demanded will depend on the behavior of its rival firms. If other firms match the price increase, the firm will move along demand curve D1 and have only a slight decrease in quantity demanded. However, if the rival firms do not match the price increase, the firm will move along demand curve D 2 and incur a much larger decrease in quantity demanded. The same principle holds for price decreases. If the firm lowers its price below P1 and other firms follow, the increase in quantity demanded will move along demand curve D1. If other firms do not match the price decrease, the firm will have a much larger increase in quantity demanded, as it will move along the relatively more elastic demand curve, D2. The behavioral assumption for managers of the firm in this model is that other firms will behave so as to inflict maximum damage on this firm. This means that other firms will not follow price increases, so that only the given firm has raised the price, but other firms will match price decreases so as to not give this firm a competitive advantage. This assumption means that the portions of the two demand curves relevant for this firm are D2 for prices above P1 and D1 for prices below P1. Thus, the firm faces a kinked demand curve, with the kink occurring at price P1. The implications of this kinked demand curve model for profit maximization can be seen by noting the shape of the marginal revenue curve. The portion of MR2 that is shown in Figure 9.1 is relevant for prices above P1, whereas the illustrated portion of MR1 is relevant for prices below P1. These are the marginal revenue curves that correspond to demand curves D2 and D1 in those price ranges. The marginal $ MC P1 MR2 MR1 0 M09_FARN0095_03_GE_C09.INDD 268 Q1 D 1: Rivals Follow Q 13/08/14 1:33 PM CHAPTER 9 Market Structure: Oligopoly 269 revenue curve is discontinuous at price P1, where the kink occurs in the demand curve. Given the marginal cost curve shown in Figure 9.1, the profit-maximizing level of output is Q1 and the optimal price is P1. As you can see in Figure 9.1, the marginal cost curve could shift up and down within the discontinuous portion of the marginal revenue curve and the profitmaximizing price and quantity would not change. This outcome is different from the standard model of a firm with market power where changes in demand and in either marginal revenue or marginal cost result in a new profit-maximizing price and quantity (Chapter 8). Likewise, if the demand curves shift out, but the kink remains at the same price, the profit-maximizing price will not change. The kinked demand curve model of oligopoly implies that oligopoly prices tend to be “sticky” and do not change as much as they would in other market structures, given the assumptions that a firm is making about the behavior of its rival firms. Critics have charged that prices in oligopoly market structures are not more rigid than in other types of markets. The kinked demand curve model also does not explain why price P1 exists initially. However, we saw examples of firms testing different price changes to determine the behavior of their rivals in the airlines examples. The kinked demand curve model is one illustration of that behavior. Game Theory Models Game theory incorporates a set of mathematical tools for analyzing situations in which players make various strategic moves and have different outcomes or payoffs associated with those moves. The tool has been applied to oligopoly behavior, given that the outcomes in this market, such as prices, quantities, and profits, are a function of the strategic behaviors adopted by the interdependent rival firms. Games can be represented by payoff tables, which show the strategies of the players and the outcomes associated with those strategies. Game theory A set of mathematical tools for analyzing situations in which players make various strategic moves and have different outcomes or payoffs associated with those moves. Dominant Strategies and the Prisoner’s Dilemma The most wellknown game theory example is the prisoner’s dilemma, which is illustrated in Table 9.2. The example assumes that two outlaws, Bonnie and Clyde, have been captured after many years on a crime spree. They are both taken to jail and interrogated separately, with no communication allowed between them. Both Bonnie and Clyde are given the options outlined in the table, with Bonnie’s options shown in bold. If neither one confesses to their crimes, there is only enough evidence to send each of them to prison for two years. However, if Bonnie confesses and Clyde does not, she will be given no prison term, while her evidence will be used to send Clyde to prison for 10 years. Clyde is made the same offer if he confesses and Bonnie does not. If both individuals confess, they will each receive a five-year prison term. We assume that even though Bonnie and Clyde have been partners in crime, each one will make the decision that is in his or her own best interest. Bonnie’s best strategy if Clyde does not confess is to confess, as she will not receive a prison TABLE 9.2 The Prisoner’s Dilemma CLYDE Bonnie M09_FARN0095_03_GE_C09.INDD 269 DON’T CONFESS CONFESS Don’t Confess 2 years, 2 years 10 years, 0 years Confess 0 years, 10 years 5 years, 5 years 13/08/14 1:33 PM 270 PART 1 Microeconomic Analysis Dominant strategy A strategy that results in the best outcome or highest payoff to a given player no matter what action or choice the other player makes. term in that case. If Clyde does confess, Bonnie’s best strategy is also to confess, as she will go to prison for only 5 years instead of the 10 years she would receive if she did not confess. Clyde’s reasoning will be exactly the same. If Bonnie does not confess, he should confess, as he will not go to prison. If Bonnie does confess, Clyde should also confess to minimize his prison sentence. Thus, both partners are led to confess, and they each end up with a prison term of five years. Both would have been better off if neither had confessed. However, in the given example, they were not able to communicate with each other, so neither one could be certain that the other partner would not confess, given the incentives of the example. Both Bonnie and Clyde would have been better off if they could have coordinated their actions or if they could have trusted each other enough not to confess. In game theory terms, both Bonnie and Clyde had a dominant strategy, a strategy that results in the best outcome or highest payoff to a given player no matter what action or choice the other player makes. If both players have dominant strategies, they will play them, and this will result in an equilibrium (both confessing, in the above example). The prisoner’s dilemma occurs when all players choose their dominant strategies and end up worse off than if they had been able to coordinate their choice of strategy. All players are prisoners of their own strategies unless there is some way to change the rules of the game. Thus, one of the basic insights of game theory is that cooperation and coordination among the parties may result in better outcomes for all players. This leads to the cooperative models of oligopoly behavior that we’ll discuss later in the chapter. The prisoner’s dilemma results may also be less serious in repeated games as learning occurs, trust develops between the players of the game, or there are clear and certain punishments for cheating on any agreement. A business example of the prisoner’s dilemma focuses on the strategies of cigarette companies for advertising on television before the practice was banned in 1970.22 The choice for competing firms was to advertise or not; the payoffs in profits in millions of dollars to each company are shown in Table 9.3. The outcomes in Table 9.3 are similar to those in the Bonnie and Clyde example in Table 9.2. Each company has an incentive to advertise because it can increase its profits by 20 percent if it advertises and the other company does not. Advertising for both companies is a dominant strategy, so the equilibrium is that both companies will advertise. However, this outcome leaves each of them with profits of $27 million compared with profits of $50 million if neither company advertised. Simultaneous advertising tends to cancel out the effect on sales for each company while raising costs for both companies. Yet neither company would choose not to advertise, given the payoffs that the other company would obtain if only one company advertised. The companies were caught in a prisoner’s dilemma. TABLE 9.3 Cigarette Television Advertising COMPANY B Company A DO NOT ADVERTISE ADVERTISE Do Not Advertise 50, 50 20, 60 Advertise 60, 20 27, 27 Source: Roy Gardner, Games for Business and Economics (New York: John Wiley, 1995), 51–53. Copyright © 1995. Reprinted by permission of John Wiley & Sons, Inc. 22 This example is drawn from Roy Gardner, Games for Business and Economics (New York: John Wiley, 1995), 51–53. M09_FARN0095_03_GE_C09.INDD 270 13/08/14 1:33 PM CHAPTER 9 Market Structure: Oligopoly 271 In this case, the rules of the game were changed by the federal government. In 1970, the cigarette companies and the government reached an agreement that the companies would place a health warning label on cigarette packages and would stop advertising on television in exchange for immunity from lawsuits based on federal law. This outcome was beneficial for the cigarette industry because it removed the advertising strategy from Table 9.3 and let all companies engage in the more profitable strategy of not advertising on television. Nash Equilibrium Many games will not have dominant strategies, in which the players choose a strategy that is best for them regardless of what strategy their rival chooses. In these situations, managers should choose the strategy that is best for them, given the assumption that their rival is also choosing his or her best strategy. This is the concept of a Nash equilibrium, a set of strategies from which all players are choosing their best strategy, given the actions of the other players. This concept is useful when there is only one unique Nash equilibrium in the game. Unfortunately, in many games, there may be multiple Nash equilibria. We illustrate a game with a unique Nash equilibrium in Table 9.4, where two firms are considering the effect on their profits of expanding their capacity.23 Their choices are no expansion, a small capacity expansion, and a large capacity expansion. Expansion of capacity would allow a firm to obtain a larger market share, but it would also put downward pressure on prices, possibly reducing or eliminating economic profits. We assume that the decisions are made simultaneously with no communication between the firms and that the profits under each strategy (in millions of dollars) are shown in the table. We can see in Table 9.4 that there isn’t a dominant strategy for either firm. If Firm 2 does not expand or plans a small expansion, Firm 1 should plan a small expansion. However, if Firm 2 plans a large expansion, Firm 1 should not expand. The same results hold for Firm 2, given the strategies of Firm 1. Thus, there is not a single strategy that each firm should pursue regardless of the actions of the other firm. There is, however, a unique Nash equilibrium in Table 9.4: Both firms plan a small expansion. Once this equilibrium is reached, each firm would be worse off by changing its strategy. However, as in the prisoner’s dilemma, both firms would be better off if they could coordinate their decisions and choose not to expand plant capacity. In that situation, each firm would have a payoff of $18 million compared with the $16 million to each firm in the Nash equilibrium. However, that outcome is not a stable equilibrium. Each firm could increase its profits through a small expansion if it thought the other firm would not expand capacity. This strategy would lead both firms to plan a small capacity expansion, the Nash equilibrium. This example also shows the benefits of coordinated behavior among the firms. Nash equilibrium A set of strategies from which all players are choosing their best strategy, given the actions of the other players. TABLE 9.4 Illustration of Unique Nash Equilibrium FIRM 2 DO NOT EXPAND SMALL EXPANSION LARGE EXPANSION Firm 1 Do Not Expand 18, 18 15, 20 9, 18 Small Expansion 20, 15 16, 16 8, 12 Large Expansion 18, 9 12, 8 0, 0 Source: David Besanko, David Dranove, and Mark Shanley, Economics of Strategy, 2nd ed. (New York: John Wiley, 2000), 37–40. Copyright © 2000. Reprinted by permission of John Wiley & Sons, Inc. 23 This example is drawn from David Besanko, David Dranove, and Mark Shanley, Economics of Strategy, 2nd ed. (New York: John Wiley, 2000), 37–40. M09_FARN0095_03_GE_C09.INDD 271 13/08/14 1:33 PM 272 PART 1 Microeconomic Analysis The above examples of the prisoner’s dilemma and Nash equilibrium are cases of simultaneous decision making. Strategies and outcomes differ if the decision making is sequential, with one side making the first move. In this case, an unconditional move to a strategy that is not an equilibrium strategy in a simultaneous-move game can give the first mover an advantage as long as there is a credible commitment to that strategy.24 Strategic Entry Deterrence Strategic entry deterrence Strategic policies pursued by a firm that prevent other firms from entering the market. Limit pricing A policy of charging a price lower than the profit-maximizing price to keep other firms from entering the market. Another way that managers in oligopoly firms can try to limit competition from rivals is to practice strategic entry deterrence, or to implement policies that prevent rivals from entering the market.25 One such policy is limit pricing, or charging a price lower than the profit-maximizing price in order to keep other firms out of the market. Figure 9.2 shows a simple model of limit pricing. Figure 9.2 shows the graphs for an established firm and for a potential entrant into the industry. The existing firm is assumed to have lower costs, given a factor such as economies of scale. The profit-maximizing level of output for the established firm is QM, where marginal revenue equals marginal cost. The price is PM, and the profit earned is represented by the rectangle (P M)AB(ATCM). Because the established firm earns positive economic profit by producing at the profitmaximizing price (PM), this profit will attract other firms into the industry. Price PM lies above the minimum point on the average total cost curve of the potential entrant (ATCEN). Thus, the positive economic profit shown in Figure 9.2 is not sustainable for the established firm over time due to entry. To thwart entry, the established firm can charge the limit price, PL, or a lower price, rather than the profit-maximizing price PM. The potential entrant would not find it profitable to enter at this price. The established firm could charge a price down to the point where its average total cost curve intersects its demand curve and still make positive or at least zero economic profit. The profit for the established firm at QL, which is represented by the rectangle (PL)CF(ATCL), is lower than the profit at QM, but it is more sustainable over time. FIGURE 9.2 $ Limit Pricing Model With limit pricing, an established firm may set a price lower than the profitmaximizing price to limit the profit incentives for potential entrants to the industry. $ ATCEN C PL PL ATCL ATCM MC A PM ATC F B D MR 0 Q (a) Potential Entrant 0 QM QL Q (b) Established Firm 24 A complete discussion of these issues in nonmathematical terms is found in Avinash K. Dixit and Barry J. Nalebuff, Thinking Strategically: The Competitive Edge in Business, Politics, and Everyday Life (New York: Norton, 1991). For a discussion of cooperative and noncooperative strategies, see Adam M. Brandenburger and Barry J. Nalebuff, Co-opetition (New York: Currency Doubleday, 1996). 25 This discussion is based on Frederic Michael Scherer and David Ross, Industrial Market Structure and Economic Performance, 3rd ed. (Boston: Houghton Mifflin, 1990), 356–71. M09_FARN0095_03_GE_C09.INDD 272 13/08/14 1:33 PM CHAPTER 9 Market Structure: Oligopoly 273 However, these strategies must be credible, in that rivals must be convinced that the established firm will continue its policy of low prices. Even profits that exist at these prices may attract entry, particularly if potential entrants are able to adopt lower-cost technologies. Thus, many dominant oligopolists lose market share over time due to entry. The established firm loses the least amount of market share when it has a high market share, when economies of scale are important, and when the minimum efficient scale of production can satisfy a large fraction of industry demand. When it introduced the Xerox 914 copier in 1959, the Xerox Corporation recognized that different degrees of competition and entry existed in the copier market based on volume of copies demanded. In the low-volume market, the company had no substantial cost advantage over competitors, so prices were set close to the profit-maximizing level with the expectation that market share would be lost to competitors. Twenty-nine firms entered this market between 1961 and 1967. In the medium- to high-volume market, Xerox had a modest to substantial cost advantage, so prices were set below the profit-maximizing level, but above the entrydeterring level. Entry by other firms was much less frequent in this market than in the low-volume market. By 1967, there were only 10 firms in the medium-volume market and 4 firms in the high-volume market. In the very high-volume market, Xerox enjoyed a substantial cost advantage protected by patents. In this market, the company was able to charge prices substantially exceeding costs for nearly a decade without attracting much entry. Predatory Pricing While limit pricing is used to try to prevent entry into the industry, predatory pricing is a strategy of lowering prices to drive firms out of the industry and scare off potential entrants. This strategy is not as widespread as often believed because the firm practicing predation must lower its price below cost and therefore incur losses itself with the expectation that these losses will be offset by future profits. The predatory firm must also convince other firms that it will leave the price below cost until the other firms leave the market. If the other firms leave and the predatory firm raises prices again, it may attract new entry. If all firms have equal costs, the predatory firm may incur larger losses than rival firms. The legal standard for predatory pricing is often considered to be pricing below marginal cost, which is typically approximated as pricing below average variable cost, given the lack of data on marginal cost. Predatory pricing A strategy of lowering prices below cost to drive firms out of the industry and scare off potential entrants. The Case of Matsushita Versus Zenith The basic issues of predatory pricing are illustrated in Figure 9.3. 26 This figure can be used to illustrate the issues in Matsushita versus Zenith, a court case in which the National Union Electric Corporation and Zenith Radio Corporation filed suit against Matsushita and six other Japanese electronic firms, accusing them of charging monopoly prices for televisions in Japan and then using those profits to subsidize belowcost television exports to the United States. In Figure 9.3, assume that PC is the pre-predation competitive price for televisions in the United States and that it is equal to a constant long-run average and marginal cost. Quantity demanded at this price is QC. Suppose that the predatory price of the Japanese sellers is PP and that in response to this price U.S. firms leave the market and cut back output, so that the total output produced by U.S. sellers is QUS. Assume also that demand remains unchanged. 26 This diagram and the discussion of Matsushita v. Zenith are based on Kenneth G. Elzinga, “Collusive Predation: Matsushita v. Zenith (1986),” in The Antitrust Revolution: Economics, Competition, and Policy, ed. John E. Kwoka, Jr., and Lawrence J. White, 3rd ed. (New York: Oxford University Press, 1999), 220–38. M09_FARN0095_03_GE_C09.INDD 273 13/08/14 1:33 PM 274 PART 1 Microeconomic Analysis FIGURE 9.3 $ Predatory Pricing Predation: Japanese share of market = QP – QUS = NM = RG Loss per unit to Japanese firms = PC – PP = NR Total loss to Japanese firms = NRGM Postpredation: U.S. price = PUS Japanese price = PJ Japanese share of market = QPP – QUS Japanese profits = RTLS K PUS PJ PC PP T R L J S G LRAC = LRMC M N Demand Marginal Revenue 0 Q US Q PP QC QP E Q The total quantity demanded at the predatory price of PP is QP, of which QUS is supplied by U.S. firms. The Japanese firms must produce the remaining output, QP – QUS. The loss to the Japanese firms is PC – PP (= NR) per unit of output, which is the difference between the predatory price and long-run average cost. Thus, the total losses to the Japanese firms are represented by the area NRGM. Assume that after predation is over, the U.S. firms are beaten back and continue to produce only output QUS, which is sold at price PUS. The Japanese now face only the “residual” demand curve, which is KE on the demand curve. The marginal revenue curve associated with this residual demand curve intersects the long-run marginal cost curve at point S, so the Japanese will charge price PJ and produce output level QPP – QUS. They will earn profits represented by the rectangle RTLS. These profits after recoupment (RTLS) must be greater than the losses suffered during predation (NRGM) for predatory pricing to be a successful policy. Although this outcome does not appear to be the case in Figure 9.3, this figure represents profits and losses for only one period. Actual benefits and costs must be measured over time, which may be a substantial number of years.27 In the court case of Matsushita versus Zenith, the economic analysis indicated that the Japanese firms could never have earned profits sufficient to recoup their losses from the alleged predatory pricing, and, therefore, the court ruled for the Japanese firms. The success of a predatory pricing policy depends on How far the predatory price is below cost The period of time during which the predatory price is in effect The rate of return used for judging the investment in predatory pricing How many rivals enter the industry after predation ends The length of time over which recoupment of profits occurs For both color and black-and-white televisions, an economic analysis showed that the Japanese firms would not be able to recoup their profits, given the size of the loss from the predatory pricing below cost and the relatively modest price increases possible during the recoupment period. However, even in the face of losses, predatory pricing in one market might still be rational if a firm achieves the reputation of being aggressive. This reputation can spill over and deter entry in other markets. 27 This process involves calculating the time value of money or the present value of the benefits and costs occurring at different points in time. These concepts are typically covered in finance courses. M09_FARN0095_03_GE_C09.INDD 274 13/08/14 1:33 PM CHAPTER 9 Market Structure: Oligopoly 275 The Case of Spirit Airlines Versus Northwest Airlines In 1996, Spirit and Northwest Airlines became involved in a price war on two domestic routes that each airline served: Detroit–Philadelphia and Detroit–Boston. 28 In 2000, Spirit filed an antitrust suit against Northwest alleging that it engaged in predatory pricing to drive Spirit from the market, so that it could raise prices to monopoly levels. Northwest argued that this strategy represented head-to-head competition and that consumers benefited from the low prices. As in the above discussion, the case revolved around market definition and whether Northwest could exercise monopoly power in the absence of Spirit Airlines and whether Northwest’s prices were below an appropriate measure of its costs. The market definition-dispute centered on whether the appropriate product market was only local passengers on the two routes or whether it also included connecting passengers. There was also disagreement about whether there were substantial barriers to entry that allowed Northwest to acquire and keep monopoly power. Arguments over costs focused on the use of marginal versus average variable costs and the definition of fixed versus variable costs. In 2005, the district court found the case in favor of Northwest Airlines and concluded that it did not engage in below-cost pricing during the period of the alleged predation. However, the U.S. Sixth Circuit Court of Appeals reversed the district court’s holding in December 2005. As part of its ruling, the Sixth Circuit Court cited studies of how low-cost carriers increased competition and lowered prices. The Court noted that Northwest had previously referred to the Detroit airport as a “unique strategic asset,” which required protection “at almost all costs.” Northwest executives had also made statements in the past that the company would match or beat potential entrants’ lowest fares, so that passengers would not have an incentive to fly with the new entrant. Cooperative Oligopoly Models The second set of oligopoly models focuses on cooperative behavior among rivals. Our examples of both the prisoner’s dilemma and the Nash equilibrium showed that the pursuit of individual strategies, while making assumptions about a rival’s behavior, could leave both firms worse off than if they had been able to collaborate or coordinate their actions. Cartels The most explicit form of cooperative behavior is a cartel, an organization of firms that agree to coordinate their behavior regarding pricing and output decisions in order to maximize profits for the organization. Figure 9.4 illustrates this concept of cartel joint profit maximization. It also illustrates why cartel members have an incentive to cheat on cartel agreements. The potential to cheat exists because what is optimal for the cartel organization may not be optimal for the individual cartel members. Model of Joint Profit Maximization For simplicity, Figure 9.4 illustrates the joint profit maximization problem for a cartel composed of two members. We have assumed that both firms have linear upward sloping marginal cost curves, but that these curves are not identical. At every level of output, Firm 1’s marginal Cartel An organization of firms that agree to coordinate their behavior regarding pricing and output decisions in order to maximize profits for the organization. Joint profit maximization A strategy that maximizes profits for a cartel, but that may create incentives for individual members to cheat. 28 This discussion is based on Kenneth G. Elzinga and David E. Mills, “Predatory Pricing in the Airline Industry: Spirit Airlines v. Northwest Airlines (2005),” in The Antitrust Revolution: Economics, Competition, and Policy, ed. John E. Kwoka, Jr., and Lawrence J. White, 5th ed. (New York: Oxford University Press, 2009), 219–47; and Kimberly L. Herb, “The Predatory Pricing Puzzle: Piecing Together a Unitary Standard,” Washington and Lee Law Review 64 (Fall 2007): 1571–617. M09_FARN0095_03_GE_C09.INDD 275 13/08/14 1:33 PM 276 PART 1 Microeconomic Analysis FIGURE 9.4 $ Cartel Joint Profit Maximization A cartel maximizes the profits of its members by producing where marginal revenue equals marginal cost for the cartel and then allocating output among its members so that the marginal cost of production is equal for each member. This procedure can give cartel members the incentive to cheat on the cartel agreement. $ MC1 MC1 MC2 MCC MCC D MR Q 1* Q (a) Firm 1 For every level of marginal cost, add the amount of output produced by each firm to determine the overall level of output produced at each level of marginal cost. $ PC 0 Horizontal summation of marginal cost curves MC2 0 Q 2* Q (b) Firm 2 0 QC Q (c) Cartel cost is higher than Firm 2’s marginal cost. The costs of production do typically vary among cartel members, which is a major cause of the cheating problem discussed later in the chapter. The marginal cost curve for the cartel (MCC) is derived from the summation of the individual firms’ marginal cost curves, or the horizontal summation of marginal cost curves.29 For every level of marginal cost measured on the vertical axis, we add the amount of output Firm 1 would produce at that marginal cost to the amount of output Firm 2 would produce at the same marginal cost to determine the cartel output at that cost. Repeating this process for various levels of marginal cost traces out the cartel marginal cost curve (MCC). For joint profit maximization, the cartel must determine what overall level of output to produce, what price to charge, and how to allocate the output among the cartel members. The demand and marginal revenue curves facing the cartel are shown in Figure 9.4c. The profit-maximizing level of output (QC) is determined by equating marginal revenue with the cartel’s marginal cost. The profit-maximizing price is, therefore, PC. Allocating Output Among Cartel Members The cartel must then decide how to allocate this total output, QC, among the two cartel members. The optimal allocation that minimizes the costs of production is achieved by having each firm produce output levels such that their marginal costs of production are equal. The intuition of this rule can be seen in Table 9.5 In this table, Firm 1’s marginal cost is always double that of Firm 2. If the goal is to produce 20 units of output overall and each firm produces 10 units, MC1 = $40, MC2 = $20, and TC1 + TC2 = $300. TABLE 9.5 Equating Marginal Cost to Minimize Total Cost FIRM 1 FIRM 2 Q MC ($) TC ($) Q MC ($) TC ($) 5 20 50 5 10 25 10 40 200 10 20 100 15 60 450 15 30 225 20 80 800 20 40 400 This simple example is based on the following equations and the assumption of zero fixed costs: TC1 = 2Q2, MC1 = 4Q, TC2 = Q2, and MC2 = 2Q. To find the cost-minimizing method of producing a total of 20 units of output, solve the equations MC1 = MC2 and Q1 + Q2 = 20. The solution is Q1 = 6.67, MC1 = $26.68, TC1 = $88.98, Q2 = 13.33, MC2 = $26.66, and TC2 = $177.69. TC1 + TC2 = $266.67. 29 This process is similar to the derivation of the market demand curve from individual firms’ demand curves (Chapter 2). M09_FARN0095_03_GE_C09.INDD 276 13/08/14 1:33 PM CHAPTER 9 Market Structure: Oligopoly 277 Firm 1 should produce less output, as it has the higher marginal cost, and Firm 2 should produce more output, as it has the lower marginal cost. As Firm 2 produces more output, its marginal cost increases, while Firm 1’s marginal cost decreases as it produces less output. As shown in Table 9.5, the cost-minimizing allocation of output between the firms is Q1 = 6.67 and Q2 = 13.33, with TC1 + TC2 = $266.67. Applying this rule to Figure 9.4, we see that Firm 1 should produce output level Q1* and Firm 2 should produce output level Q2* so that their marginal costs of production are equal to each other and to the cartel’s marginal cost. The optimal outputs for Firms 1 and 2 are equal to the total cartel output (Q1* + Q2* = QC), as shown by the construction of the cartel marginal cost curve. This allocation rule for joint profit maximization is summarized in Equation 9.1: 9.1 MC1 = MC2 = MCC where MC1 = Firm 1=s marginal cost MC2 = Firm 2=s marginal cost MCC = cartel=s marginal cost (derived from horizontal summation of the firm=s marginal cost curves) Cheating in Cartels By solving the cartel joint profit-maximization problem, we can see the incentive for cheating in cartels. In Figure 9.4, the optimal level of output for Firm 1 is much less than the level of output for Firm 2. If Firm 1’s marginal cost curve had intersected the axis above the value MC C, its optimal allocation of output would have been zero. Joint profit maximization when firms have unequal costs of production implies that these firms’ output shares will be unequal. If they are expected to sell this output at the cartel profit- maximizing price, the profits of the two firms will be quite different. Both firms have an incentive to expand output to the point where the cartel price (PC) equals their marginal cost of production because this would be the best strategy for profit maximization by each individual firm. Cartel Success A cartel is likely to be the most successful when 1. It can raise the market price without inducing significant competition from noncartel members. 2. The expected punishment for forming the cartel is low relative to the expected gains. 3. The costs of establishing and enforcing the agreement are low relative to the gains.30 If a cartel controls only a small share of the market, it can expect significant competition from noncartel members. The existence of positive economic profits from the cartel pricing policy is also likely to attract more competition. In the United States, price- and output-fixing agreements were made illegal by the Sherman Antitrust Act of 1890. Germany, Japan, and the United Kingdom once permitted the formation of cartels that their governments thought would increase efficiency. More recently, countries in the European Union have adopted antitrust laws similar to those in the United States. In these cases, with the expected punishment 30 This discussion is based on Dennis W. Carlton and Jeffrey M. Perloff, Modern Industrial Organization, 4th ed. (Boston: Pearson Addison-Wesley, 2005), 122–56. For an extensive discussion with numerous examples on how cartels are organized, see Herbert Hovenkamp and Christopher R. Leslie, “The Firm as Cartel Manager,” Vanderbilt Law Review 64 (April 2011): 811–73. M09_FARN0095_03_GE_C09.INDD 277 13/08/14 1:33 PM 278 PART 1 Microeconomic Analysis for explicit agreements very severe, firms must consider the expected costs and benefits of less formal behavior, to be discussed below. The costs of organizing a cartel will be lower if there are few firms involved, the market is highly concentrated, the firms are producing nearly identical products, and a trade association exists. All of these factors lower the costs of negotiating and bargaining among the cartel members. Cartels try to prevent cheating by dividing the market into specific buyers and geographic areas or by agreeing to fix market shares. Contracts may include agreements to a buyer that the seller is not selling at a lower price to another buyer. Cartel agreements may also include a trigger price. If the market price drops below this trigger price, firms can expand output to their precartel levels or abandon the cartel agreement. Well-Known Cartels: OPEC Perhaps the most well-known cartel is OPEC— the Organization of Petroleum Exporting Countries—founded by Saudi Arabia, Iran, Iraq, Kuwait, and Venezuela in 1960 to counter the market power of the major international oil companies.31 During the early 1970s, world oil demand was at an all-time high, while the supply was increasingly concentrated in the low-production-cost countries of the Middle East. There was also a fringe of nonOPEC suppliers, but these countries faced substantially higher development and operating costs. In response to Western support for Israel during the Egyptian– Israeli War of 1973, OPEC instituted production cutbacks and an oil embargo against the West. The price of oil rose from less than $10 a barrel to over $30 per barrel as a result of this action. Another oil price increase occurred after the fall of the Shah of Iran in 1979. Oil demand in the United States declined sharply after the second price shock, and energy use in the European Union and Japan also began to decline. At the same time, oil output of OPEC member Venezuela and non-OPEC producers increased. The pricing behavior of the cartel resulted in the entry of new oil producers and changed consumer behavior, substantially weakening the cartel. Saudi Arabia is the dominant player in the cartel, given its vast reserves of oil and its cost advantage in production. Thus, there are different incentives facing cartel members, as well as the competitive supply from non-OPEC members. OPEC members Saudi Arabia, Kuwait, and the United Arab Emirates have vast oil reserves, small populations, and large economies, so they are more conservative about selling oil for revenues than are poorer countries with large populations, such as Indonesia, Nigeria, and Algeria. OPEC’s market share fell to 30 percent by 1985, largely due to production cutbacks by Saudi Arabia. Internal dissension about quotas occurred among OPEC members from the late 1980s to the 1990s. The major Arab oil producers expanded their output following the Gulf War in 1991, as bargaining power within OPEC seemed to be related to production capacity. Member quotas were raised in 1997 in anticipation of increased world demand. This did not materialize, so prices fell that year. Since 2000, a similar pattern has continued, with OPEC members trying to enforce quotas, but with substantial competition from non-OPEC producers severely limiting the strength of the cartel.32 In fall 2001, OPEC producers predicted that oil prices could fall to $10 per barrel. They argued that such a price drop might be the only way to make non-OPEC producers limit their output, which they had refused 31 This discussion is based on Stephen Martin, “Petroleum,” in The Structure of American Industry, eds. Walter Adams and James Brock, 10th ed. (Upper Saddle River, NJ: Prentice Hall, 2001), 28–56. 32 “Non-OPEC Output Rose in November Weakening OPEC’s Role in Oil Market,” Dow Jones Newswires, December 13, 2001; “Russia Says It Will Phase Out Restrictions on Oil Exports,” Wall Street Journal, May 19, 2002; Jim Efstathiou, “OPEC Members Wary of Looming Higher Non-OPEC Oil Supply,” Wall Street Journal, May 20, 2002. M09_FARN0095_03_GE_C09.INDD 278 13/08/14 1:33 PM CHAPTER 9 Market Structure: Oligopoly 279 to do previously. OPEC members, excluding Iraq, had cut oil production by 290,000 barrels per day, but non-OPEC countries, such as Russia, Angola, and Kazakhstan, had increased output by 630,000 barrels per day. OPEC members reduced production in early 2002, but also pressured non-OPEC countries to do the same. Russia, Norway, Mexico, Oman, and Angola responded, but several months later Russia announced that it was planning to increase exports again. These actions on the part of both OPEC and non-OPEC members illustrate how difficult it is to maintain cartel behavior. In fall 2006, there was again downward pressure on oil prices. OPEC had to decide what price to defend with a total limit on production and how to allocate quotas among members. OPEC officials publicly contradicted themselves over what type of system they were discussing. Many oil ministers suggested $55 per barrel of U.S. benchmark crude as the price the group would defend, although some wanted a price closer to $60. At this point OPEC had split into two camps. One group of countries, including Kuwait, Algeria, and Libya, were able to greatly exceed the individual production quotas OPEC had assigned each member. Other countries, such as Venezuela, Iran, and Indonesia, struggled to meet their quotas. Saudi Arabia had already been quietly trimming its output in the previous several months.33 By the fall of 2007, world demand drove oil prices to the $70 range in September and close to $100 per barrel by November. This created a different set of problems for the cartel. In September 2007, the cartel raised its output limits so that it would not appear to be benefiting while many of the world’s economies slowed. Saudi Arabia, with its large reserves, again took the lead in increasing output. Many of the other countries were already pumping oil to the limit. At the OPEC meeting in November 2007, there was discussion about whether the current high prices were justified. The Saudi oil minister, the cartel’s de facto leader, suggested he would prefer to see prices come down as did officials from the United Arab Emirates. However, Venezuela and Iran both defended the prices as fair. Venezuelan President Hugo Chavez also called for a return of the 1970s-style “revolutionary OPEC,” although this view was not accepted by the Saudis.34 These divisions among OPEC members continued in recent years.35 At an acrimonious meeting in June 2011, a group led by Saudi Arabia, Kuwait, Qatar, and the United Arab Emirates pushed for an increase in oil production of 1.5 million barrels a day, which would have brought OPEC’s total production to 30.3 million barrels per day or approximately one-third of world supplies. The Saudis were blocked by six members, including Iran, Algeria, Angola, Venezuela, Ecuador, and Libya, who argued that the demand for oil would remain soft. Analysts noted that this was a split between the “haves” and “have-nots” in the cartel and reflected underlying political divisions over the Arab Spring democracy movement. Some analysts noted that Saudi Arabia might unilaterally increase its own production despite its stated quota. In February 2012, OPEC cut its demand-growth projections for 2012 by one-third, given the slowing of Asian economies. However, the cartel was still producing almost a million barrels per day above a target established in December 2011. Analysts expected this trend could increase strife among the cartel members. 33 Bhushan Bahree, “A Slippery Debate Stirs in OPEC,” Wall Street Journal, September 22, 2006; Chip Cummins, “Oil-Price Drop Challenges OPEC Unity,” Wall Street Journal, October 19, 2006. 34 Peter Fritsch and Oliver Klaus, “OPEC Seeks Soft Landing for Oil,” Wall Street Journal, September 12, 2007; Neil King, Jr., “OPEC’s Divisions Rise to Surface,” Wall Street Journal, November 19, 2007. 35 This discussion is based on Summer Said, Hassan Hafidh, and Benoit Faucon, “Meeting Casts Doubt on OPEC’s Influence,” Wall Street Journal (Online), June 8, 2011; and Benoit Faucon, “OPEC Cuts Oil Demand View but Still Pumps More,” Wall Street Journal (Online), February 9, 2012. M09_FARN0095_03_GE_C09.INDD 279 13/08/14 1:33 PM 280 PART 1 Microeconomic Analysis The Diamond Cartel The international diamond cartel, which organizes the production side of the diamond market, may be the most successful and enduring cartel in the world.36 DeBeers, the dominant company in the industry, was founded in 1880 and has been controlled by a single South African family, the Oppenheimers, since 1925. Eight countries—Botswana, Russia, Canada, South Africa, Angola, Democratic Republic of Congo, Namibia, and Australia—produce most of the world’s gem diamonds under a system with an explicit set of rules. These countries adjust production to meet expected demand, stockpile excess diamonds, and sell most of their output to the Diamond Trading Company in London, which is owned by DeBeers. Cecil Rhodes, the founder of DeBeers, realized from the start that the company needed to control the supply of diamonds to maintain their scarcity and perceived value and that the South African individual miners would be unable to control production. The solution was to organize a vertically integrated organization to manage the flow of diamonds from South Africa. Rhodes organized the Diamond Syndicate under which distributors would buy diamonds from him and sell them in agreed-upon numbers and at agreed-upon prices. This organization was taken over by the Oppenheimers, who, over the years, took new diamond producers into the fold. Demand was managed through the introduction of the slogan, “A diamond is forever,” in 1948, which implicitly told customers that the product was too valuable ever to be resold and that diamonds equal love. Even the controversy over “blood” or “conflict” diamonds benefited the cartel. Around the year 2000, activists began arguing that warlords in Sierra Leone, Liberia, the Congo, and elsewhere funded their brutal activities by the sale of diamonds and that these diamonds should be boycotted, a move that would have had a major impact on DeBeers. The end result of this controversy was the Kimberly Process, an international program begun in 2002 and supported by the producing countries, importing countries, nongovernmental organizations, the jewelry trade, and the United Nations. This program included a complex certification system for all diamonds regarding their origin and a commitment by all participants to adhere to the rules of the system. DeBeers wholeheartedly supported this program because the end result was to keep excess supplies off the market and prevent entry by new suppliers. Warlords and other small suppliers were kept out of the market, and the additional costs of tagging, monitoring, and auditing made entry more difficult for new and smaller players. Both DeBeers and the Canadian producers were the major beneficiaries of this program. By the fall of 2011, there were further changes in the diamond cartel.37 The Oppenheimers sold their remaining 40 percent stake in DeBeers to the mining giant Anglo American for over $5 billion. The family was concerned that too much of its fortune was tied up in one commodity, so there was a constant risk of a market crash. An increased number of diamond suppliers had fragmented old partnerships over many years. Many analysts saw the diamond industry consolidating, similar to the mining industry in general, with major players, such as Anglo American and Rio Tinto, spending billions to gain control of their mineral assets. Demand was expected to remain strong in the West and to increase in China, India, and the Middle East. 36 This discussion is based on Debora L. Spar, “Continuity and Change in the International Diamond Market,” Journal of Economic Perspectives 20 (Spring 2006): 195–208. For a further analysis, see Peter A. Stanwick, “DeBeers and the Diamond Industry: Squeezing Blood Out of a Precious Stone,” International Journal of Case Studies in Management 9 (November 2011): 1–29. 37 This discussion is based on Sugata Ghosh and Ram Sahgal, “Diamond Houses Keep Fingers Crossed After Change of Guard at DeBeers,” The Economic Times (Online), December 13, 2011; and Richard Warnica, “Diamonds Aren’t Forever,” Maclean’s, January 16, 2012. M09_FARN0095_03_GE_C09.INDD 280 13/08/14 1:33 PM CHAPTER 9 Market Structure: Oligopoly 281 Tacit Collusion Because cartels are illegal in the United States due to the antitrust laws, firms may engage in tacit collusion, coordinated behavior that is achieved without a formal agreement. Practices that facilitate tacit collusion include 1. 2. 3. 4. 5. Uniform prices A penalty for price discounts Advance notice of price changes Information exchanges Swaps and exchanges38 However, managers must be aware that many of these practices have been examined by the Justice Department and the Federal Trade Commission (FTC) to determine whether they have anticompetitive effects. Cases are often ambiguous because these practices can also increase efficiency within the industry. Charging uniform prices to all customers of a firm makes it difficult to offer discounts to customers of a rival firm. This policy may be combined with policies that require that any decreases in prices be passed on to previous customers in a certain time period, as well as to current customers. This strategy decreases the incentives for a firm to lower prices. Price changes always cause problems for collusive behavior, as the firm that initiates the change never knows whether its rivals will follow. In some cases, there is formal price leadership, in which one firm, the acknowledged leader in the industry, will institute price increases and wait to see if they are followed. This practice was once very common in the steel industry. However, price leadership can impose substantial costs on the leader if other firms do not follow. A less costly method is to post advance notices of price changes, which allows other firms to make a decision about changing their prices before the announced price increase actually goes into effect. We will discuss this practice in more detail below. Collusive behavior may also be strengthened by information exchanges, as when firms identify new customers and the prices and terms offered to them. This policy can help managers avoid price wars with rival firms. However, in the Hardwood Case (1921), lumber producers, who ran the American Hardwood Manufacturers Association, collected and disseminated pricing and production information. Although the industry was quite competitive, with 9,000 mills in 20 states and only 465 mills participating in the association, the Supreme Court ruled that the behavior violated the Sherman Antitrust Act, and the information exchange was ended. Firms may also engage in swaps and exchanges in which a firm in one location sells output to local customers of a second firm in another location in return for the reciprocal service from the second firm. This practice occurs in the chemical, gasoline, and paper industries, where the products are relatively homogeneous and transportation costs are significant. These swaps can allow firms to communicate, divide the market, and prevent competition from occurring. Tacit collusion Coordinated behavior among oligopoly firms that is achieved without a formal agreement. Price leadership An oligopoly strategy in which one firm in the industry institutes price increases and waits to see if they are followed by rival firms. The Ethyl Case In the Ethyl Case (1984), the FTC focused on several facilitating practices that it claimed resulted in anticompetitive behavior among the four producers of lead-based antiknock compounds used in the refining of gasoline— the Ethyl Corporation, DuPont, PPG Industries, and Nalco Chemical Company.39 38 This discussion is based on Carlton and Perloff, Modern Industrial Organization, 379–87. George A. Hay, “Facilitating Practices: The Ethyl Case (1984),” in The Antitrust Revolution: Economics, Competition, and Policy, ed. John E. Kwoka, Jr., and Lawrence J. White, 3rd ed. (New York: Oxford University Press, 1999), 182–201. 39 M09_FARN0095_03_GE_C09.INDD 281 13/08/14 1:33 PM 282 PART 1 Microeconomic Analysis The practices included advance notices of price changes, press notices, uniform delivered pricing, and most-favored-customer clauses. All four firms gave their customers notices of price increases at least 30 days in advance of the effective date. Thus, other firms could respond to the first increase before it was implemented. Until 1977, the firms issued press notices about the price increases, which provided information to their rivals. All firms quoted prices on the basis of a delivered price that included transportation, and the same delivered price was quoted regardless of a customer’s location. This delivered pricing strategy removed transportation costs from the pricing structure and simplified each producer’s pricing format, making it easier to have a uniform pricing policy among the firms. The firms also used most-favored-customer clauses, in which any discount off the uniform delivered list price given to a single customer would have to be extended to all customers of that seller. The effect of these clauses was to prevent firms from stealing rivals’ customers by lowering prices to certain customers. This could easily happen in the antiknock compound industry because sales were made privately to each of the industrial customers and might not be easily detected by rivals. These clauses meant that the uncertainty about rivals’ prices and pricing decisions was reduced. In this case, the FTC ruled against the industry, but the court of appeals overruled this decision. Much of the appellate court’s decision was based on the fact that many of these practices were instituted by the Ethyl Corporation before it faced competition from the other rivals, and, therefore, the court concluded the purpose of these practices was not to reduce competition. Airline Tariff Publishing Case Similar issues regarding communication of advanced pricing information arose in the Airline Tariff Publishing Case (1994).40 In December 1992, the Justice Department filed suit against the Airline Tariff Publishing Company (ATPCO) and eight major airlines, asserting that they had colluded to raise prices and restrict competition. The Justice Department charged that the airlines had used ATPCO, the system that disseminates fare information to the airlines and travel agency computers, to carry on negotiations over price increases in advance of the actual changes. The system allowed the airlines to announce a fare increase to take effect some number of weeks in the future. Often the airlines iterated back and forth until they were all announcing the same fare increase to take effect on the same date. The Justice Department alleged that the airlines used fare basis codes and footnote designators to communicate with other airlines about future prices. The airlines argued that they were engaging in normal competitive behavior that would also benefit consumers, who were often outraged when the price of a ticket increased between the time they made the reservation and the time they purchased the ticket. The Justice Department believed that any benefits of these policies were small compared with the ability of the airlines to coordinate price increases. Under the settlement of the case, the airlines cannot use fare basis codes or footnote designators to convey anything but very basic information; they cannot link different fares with special codes; and they cannot pre-announce price increases except in special circumstances. The settlement does not restrict what fares an airline can offer or when specific fares can be implemented or ended. Since this antitrust dispute, the airlines have engaged in pricing practices discussed in the opening case—that is, posting an increase on a Friday afternoon, waiting to see if the rivals respond, and then either leaving the increase in place or abandoning it by Monday morning. 40 Severin Borenstein, “Rapid Price Communication and Coordination: The Airline Tariff Publishing Case (1994),” in The Antitrust Revolution: Economics, Competition, and Policy, eds. John E. Kwoka, Jr., and Lawrence J. White, 3rd ed. (New York: Oxford University Press, 1999), 310–26. M09_FARN0095_03_GE_C09.INDD 282 13/08/14 1:33 PM CHAPTER 9 Market Structure: Oligopoly 283 Managerial Rule of Thumb Coordinated Actions Managers in oligopoly firms have an incentive to coordinate their actions, given the uncertainties inherent in noncooperative behavior. Their ability to coordinate, however, is constrained by a country’s antitrust legislation, such as the prohibition on explicit cartels and the limits placed on many types of tacit collusion in the United States. There are also incentives for cheating in coordinated behavior. It is often the case that any type of behavior that moderates the competition among oligopoly firms is likely to be of benefit to them even if formal agreements are not reached. However, oligopolists, like all firms with market power, must remember that this power can be very fleeting, given the dynamic and competitive nature of the market environment. ■ Summary In this chapter, we have focused on the interdependent behavior of oligopoly firms that arises from the small number of participants in these markets. Managers in these firms develop strategies based on their judgments about the strategies of their rivals and then adjust their own strategies in light of their rivals’ actions. Because this type of noncooperative behavior can leave all firms worse off than if they coordinated their actions, there are incentives for either explicit or tacit collusion in oligopoly markets. Explicit collusive agreements may be illegal and are always difficult to enforce. Many oligopolists turn to forms of tacit collusion, but managers of these firms must be aware that their actions may come under scrutiny from governmental legal and regulatory agencies. Key Terms joint profit maximization, p. 275 kinked demand curve model, p. 268 limit pricing, p. 272 Nash equilibrium, p. 271 noncooperative oligopoly models, p. 267 cartel, p. 275 cooperative oligopoly models, p. 267 dominant strategy, p. 270 game theory, p. 269 horizontal summation of marginal cost curves, p. 276 oligopoly, p. 262 predatory pricing, p. 273 price leadership, p. 281 strategic entry deterrence, p. 272 tacit collusion, p. 281 Exercises Technical Questions 1. The following graph shows a firm with a kinked demand curve. P MC a. What assumption lies behind the shape of this demand curve? b. Identify the firm’s profit-maximizing output and price. c. Use the graph to explain why the firm’s price is likely to remain the same, even if marginal costs change. 2. The following matrix shows strategies and payoffs for two firms that must decide how to price. Firm 2 D Q MR M09_FARN0095_03_GE_C09.INDD 283 FIRM 1 PRICE HIGH PRICE LOW PRICE HIGH 400, 400 700, –50 PRICE LOW –50, 700 100, 100 13/08/14 1:33 PM 284 PART 1 Microeconomic Analysis a. Does either firm have a dominant strategy, and if so, what is it? b. What is the Nash equilibrium of this game? c. Why would this be called a prisoner’s dilemma game? 3. Suppose Marcus and Sophia are playing tennis and it is Marcus’s turn to hit the ball and Sophia’s to receive it. If Sophia can receive the ball, she will get 1 point and Marcus will get 0. However, if she fails to receive the ball, Marcus will get 1 point and she will get 0. Marcus can hit the ball either to the right or to the left, and Sophia can receive the ball on either side. a. Draw a payoff table that shows the strategies of Marcus and Sophia and the outcomes associated with those strategies. b. Does either player have a dominant strategy? c. Is there a Nash equilibrium in this game? Explain. 4. Some games of strategy are cooperative. One example is deciding which side of the road to drive on. It doesn’t matter which side it is, as long as everyone chooses the same side. Otherwise, everyone may get hurt. Driver 2 DRIVER 1 LEFT RIGHT LEFT 0, 0 –1000, –1000 RIGHT –1000, –1000 0, 0 a. Does either player have a dominant strategy? b. Is there a Nash equilibrium in this game? Explain. c. Why is this called a cooperative game? 5. A monopolist has a constant marginal and average cost of $10 and faces a demand curve of QD = 1000 – 10P. Marginal revenue is given by MR = 100 – 1/5Q. a. Calculate the monopolist’s profit-maximizing quantity, price, and profit. b. Now suppose that the monopolist fears entry, but thinks that other firms could produce the product at a cost of $15 per unit (constant marginal and average cost) and that many firms could potentially enter. How could the monopolist attempt to deter entry, and what would the monopolist’s quantity and profit be now? c. Should the monopolist try to deter entry by setting a limit price? 6. Consider a market with a monopolist and a firm that is considering entry. The new firm knows that if the monopolist “fights” (i.e., sets a low price after the entrant comes in), the new firm will lose money. If the monopolist accommodates (continues to charge a high price), the new firm will make a profit. M09_FARN0095_03_GE_C09.INDD 284 Entrant MONOPOLIST ENTER 20, 10 5, –10 PRICE HIGH PRICE LOW DON’T ENTER 50, 0 10, 0 a. Is the monopolist’s threat to charge a low price credible? That is, if the entrant has come in, would it make sense for the monopolist to charge a low price? Explain. b. What is the Nash equilibrium of this game? c. How could the monopolist make the threat to fight credible? 7. The following graphs show a monopolist and a potential entrant. $ P MCE MC ATCE ATC D Q Potential Entrant MR Monopolist Q a. Label the monopolist’s profit-maximizing price and quantity. b. Identify a limit price that the monopolist could set to prevent entry. c. How much does the monopolist lose by setting a limit price rather than the profit-maximizing price? Does that mean that this would be a bad strategy? 8. The following table shows the demand for Good X, which is only produced by two firms. These two firms have just formed a cartel. Suppose that the two firms have a constant marginal cost and an average total cost of $55. Quantity (thousands of units) 0 1 2 3 4 5 6 7 Price (dollars per unit) 100 95 90 85 80 75 70 65 a. What are the cartel’s profit-maximizing output and price? b. What are the output and profit for each firm? c. What will happen to the profits of both firms if one of them cheats and increases its output by 1,000 units, while the other doesn’t? 13/08/14 1:33 PM CHAPTER 9 Market Structure: Oligopoly 285 Application Questions 1. In current business publications, find examples of the continued oligopolistic behavior among the airlines similar to what we discussed in this chapter. 2. The following paragraphs provide a description of the strategy used by Morrisons to raise its sales41: Morrisons, one of the “big four” supermarkets in the UK, has been losing market share to some discount chains in recent years. Its sales fell by 3.2 percent in 2013. In order to compete with those discount chains and the other supermarkets at par with it, Morrisons is going to slash the price of a basket of everyday products, such as bread, eggs, chicken breasts, minced beef, fresh fruit, and vegetables. After Morrisons’ announcement of its strategy, all of its traditional rivals, Sainsbury’s, Tesco, and Asda, have pledged to follow the price reduction. The market is expecting a price war among the “big four” supermarket chains. Explain how the discussion of Morrisons’ strategy and the reaction of its rivals relates to the kinked demand curve model. 3. The following describes the ice cream industry in summer 2003:42 Given the Federal Trade Commission’s approval of Nestle’s acquisition of Dreyer’s Grand Ice Cream Inc., two multinationals, Nestle SA and Unilever, prepared to engage in ice cream wars. Unilever, which controlled the Good Humor, Ben & Jerry’s, and Breyer’s brands, held 17 percent of the U.S. market, while Nestle, owner of the Haagen-Dazs and Drumstick brands, would control a similar share after buying Dreyer’s. Ice cream has long been produced by small local dairies, given the problems with distribution. Most Americans eat ice cream in restaurants and stores, although 80 percent of the consumption of the big national brands occurs at home. Both Unilever and Nestle want to move into the away-fromhome market by focusing on convenience stores, gas stations, video shops, and vending machines, a strategy the rivals have already undertaken in Europe. Five national brands—Haagen-Dazs, Nestle, Ben & Jerry’s, Breyer’s, and Dreyer’s— have developed new products and flavors, focusing on single-serving products that carry profit margins 15 to 25 percent higher than the tubs of ice cream in supermarkets. The higher profit margins can open new distribution outlets. Although traditional freezer space is very costly, Unilever, Nestle, and Dreyer’s have pushed for logo-covered freezer cabinets in stores, given the higher profit margins. Under the FTC settlement, Nestle will be allowed to keep Dreyer’s distribution network, which delivers ice cream directly to more than 85 percent of U.S. grocers. Unilever must use middlemen to deliver most of its Good Humor and Breyer’s products. Nestle can expand from Dreyer’s supermarket base to cinemas and gas stations with little extra cost. The supermarket ties may also help Nestle enter grocers’ competitive prepared-foods section, so that consumers can easily purchase ice cream along with their deli and hot foods. Nestle agreed to sell a number of Dreyer’s secondary brands as part of the FTC 41 John Coates and Scott Campbell, “Morrisons the First to Unleash Huge Discounts in Supermarket Price War,” Express (Online), March 16, 2014. 42 Deborah Ball, “Ice Cream Rivals Prepare to Wage a New Cold War,” Wall Street Journal, June 26, 2003. M09_FARN0095_03_GE_C09.INDD 285 13/08/14 1:33 PM 286 PART 1 Microeconomic Analysis approval. However, Nestle-Dreyer’s will be able to sign more licensing agreements with the wider distribution network, and the combined company will be able to turn more of Nestle’s candies into Dreyer’s ice cream. a. Describe how the ice cream industry fits the oligopoly model. b. How does the government influence oligopolistic behavior? c. Do oligopolists always compete on the basis of price? Explain. 4. The following describes the competition between Google and Amazon for fast delivery of customer products.43 In 2011, Google, Inc. began to challenge Amazon’s e-commerce dominance by engaging in discussions with major retailers and shippers about creating a service that would let customers shop online and receive their orders within a day for a low fee. This was a direct challenge to the Amazon Prime program that, for $79 per year, offered customers fast shipping at no additional charge for many items on the company’s website. Amazon Prime increased the company’s sales by 42% in the first nine months of 2011. Google did not plan to sell products directly to consumers. The goal was to meld its search engine’s product-search feature with a new quick-shipping service that Google would control. Both Google and Amazon had been moving toward similar strategies. Amazon had become a destination for product searches and a big seller of online advertising, encroaching on Google’s territory. Google responded by moving into the online retail industry, dominated by Amazon, that was expected to grow 12% to $197 billion in 2011. Analysts noted that same-day shipping was a costly and complex business. However, Google expected that the quick-shipping service would attract more consumers to its product-search service. Google had increased the quality of its product-search service by adding user ratings and reviews and helping customers determine where merchandise was available for pickup. Google’s new strategy would also put it in competition with eBay and Shoprunner Inc., both of which had fastshipping programs. Describe the strategies used by these oligopolists to fight the fast-shipping wars. 5. The following describes the relationship between two major shipping companies hauling liquid chemicals:44 Documents indicated that two shipping companies, Stolt-Nielsen SA and Odfjell ASA, colluded to divide up the market for transporting liquid chemicals across the sea. The companies discussed which shipping business each would bid for, route by route, even exchanging information on bid prices. Stolt officials also developed tables showing the increase in revenues from cooperation compared to all-out competition. The companies are unknown to most consumers, but they carry the chemicals that are used to make a variety of everyday products. Carriers are allowed to cooperate in certain ways. They m...
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Surname 1
Name
Tutor
Course
Date
Chapter 9: Application Questions, (page 26-28 in PDF)
Question 3
The following describes the ice cream industry in summer 2003:
Given the Federal Trade Commission’s approval of Nestle’s acquisition of Dreyer’s Grand
Ice Cream Inc., two multinationals, Nestle SA and Unilever, prepared to engage in ice
cream wars. Unilever, which controlled the Good Humor, Ben & Jerry’s, and Breyer’s
brands, held 17 percent of the U.S. market, while Nestle, owner of the Haagen-Dazs and
Drumstick brands, would control a similar share after buying Dreyer’s. Ice cream has long
been produced by small local dairies, given the problems with distribution. Most
Americans eat ice cream in restaurants and stores, although 80 percent of the consumption
of the big national brands occurs at home. Both Unilever and Nestle want to move into the
away-from home market by focusing on convenience stores, gas stations, video shops, and
vending machines, a strategy the rivals have already undertaken in Europe. Five national
brands—Haagen-Dazs, Nestle, Ben & Jerry’s, Breyer’s, and Dreyer’s— have developed
new products and flavors, focusing on single-serving products that carry profit margins 15
to 25 percent higher than the tubs of ice cream in supermarkets. The higher profit margins
can open new distribution outlets. Although traditional freezer space is very costly,
Unilever, Nestle, and Dreyer’s have pushed for logo-covered freezer cabinets in stores,
given the higher profit margins. Under the FTC settlement, Nestle will be allowed to keep
Dreyer’s distribution network, which delivers ice cream directly to more than 85 percent of
U.S. grocers. Unilever must use middlemen to deliver most of its Good Humor and
Breyer’s products. Nestle can expand from Dreyer’s supermarket base to cinemas and gas
stations with little extra cost. The supermarket ties may also help Nestle enter grocers’
competitive prepared-foods section, so that consumers can easily purchase ice cream along
with their deli and hot foods. Nestle agreed to sell a number of Dreyer’s secondary brands
as part of the FTC approval. However, Nestle-Dreyer’s will be able to sign more licensing
agreements with the wider distribution network, and the combined company will be able to
turn more of Nestle’s candies into Dreyer’s ice cream.
a) Describe how the ice cream industry fits the oligopoly model.
The ice cream industry does fit the oligopoly model, with two multinationals, Nestle and
Unilever, controlling 34 percent of the market. The behavior of the two companies is
interdependent.

Surname 2
b) How does the government influence oligopolistic behavior?
The ice cream industry does fit the oligopoly model, with two multinationals, Nestle and
Unilever, controlling 34 percent of the market. The behavior of the two companies is
interdependent.

c) Do oligopolists always compete on the basis of price? Explain.
Although these oligopolists are competing on price, that fact is not mentioned in the discussion.
Most of the discussion focuses on the rivals’ attempts to capture the away-from-home ice cream
market in convenience stores, gas stations, and video shops. The distribution network and access
to supermarkets are also key components of the firms’ competitive strategies. Both firms are
developing new single-serving products that have higher profit margins. Nestle is also working
to turn more of its candies into ice cream flavors.

Question 4
The following describes the competition between Google and Amazon for fast delivery of
customer products.
In 2011, Google, Inc. began to challenge Amazon’s e-commerce dominance by engaging in
discussions with major retailers and shippers about creating a service that would let
customers shop online and receive their orders within a day for a low fee. This was a direct
challenge to the Amazon Prime program that, for $79 per year, offered customers fast
shipping at no additional charge for many items on the company’s website. Amazon Prime
increased the company’s sales by 42% in the first nine months of 2011. Google did not plan
to sell products directly to consumers. The goal was to meld its search engine’s productsearch feature with a new quick-shipping service that Google would control. Both Google
and Amazon had been moving toward similar strategies. Amazon had become a destination
for product searches and a big seller of online advertising, encroaching on Google’s
territory. Google responded by moving into the online retail industry, dominated by
Amazon, that was expected to grow 12% to $197 billion in 2011. Analysts noted that sameday shipping was a costly and complex business. However, Google expected that the quickshipping service would attract more consumers to its product-search service. Google had
increased the quality of its product-search service by adding user ratings and reviews and
helping customers determine where merchandise was available for pickup. Google’s new
strategy would also put it in competition with eBay and Shop runner Inc., both of which
had fast shipping programs.

Surname 3
Describe the strategies used by these oligopolists to fight the fast-shipping wars.
Oligopoly is a market structure in which a few firms dominate the industry; it is an industry with
a five firm concentration ratio of greater than 50%.
The strategies which are used by these oligopolists to fight the fast-shipping wars are;
i.

Personalized pricing

The main goal of this strategy is to determine how much each individual customer is willing to
pay for the product and to charge him or her accordingly. For example, Amazon only asks for
your name when your register on the website, but it carefully tracks what you have purchased
and collects personal information about your buying habits. Personalization helps them identify
your interests and your willingness to pay. Once you make a purchase, you are presented with
recommendations based on previous purchases.
ii.

Promotional pricing

This strategy i...


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